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Money Talks: MLPs an Attractive Option

The recently-released federal budget outlines the Obama administration’s tax and spending proposals for 2010 and future years. Although it contains tax increases for certain taxpayers, notably absent are any provisions aimed at master limited partnerships (MLPs), a welcome sign for those waiting to see whether the administration would begin taxing these businesses. As taxes increase, MLPs are becoming a more attractive option for Oklahoma businesses.An MLP is a type of business entity that combines a partnership’s tax benefits with the liquidity of publicly traded securities. An MLP’s sponsor company serves as its general partner, managing the partnership, while its limited partners are public investors who are not involved in its management or operations. MLPs must pay a minimum quarterly distribution to their limited partners. An MLP’s general partner has incentive distribution rights, which allow it to receive a higher portion of distribution payments as the distributions grow beyond target levels. MLPs originated as a result of tax laws intended to encourage investment in the energy and natural resources industries. Pursuant to such laws, MLP investors are not subject to double taxation. MLP owners are only taxed at the individual level, while shareholders of a corporation are taxed twice – at the corporate level and again at the personal level. MLP investors also enjoy deferral of taxes. Almost 90 percent of cash distributions are not taxed until the associated unit is sold. As a result, unitholders often pay a minimal tax rate on distributions.Creation of an MLP provides several benefits to the business that creates it. One such benefit is the competitive advantage resulting from the lack of double taxation. An MLP’s lower cost of capital allows it to pay more for an acquisition than a corporation would pay yet realize the same cash flow accretion, or realize more accretion from an acquisition given the same acquisition price. Another benefit is that assets within an MLP typically trade at higher valuations than the same assets held by a corporation. Yet another advantage is the ability of the company creating the MLP to maintain control of its assets through its general partner interest, but receive an infusion of capital from several new investors. The company creating the MLP also benefits from the ability to capture future upside through the incentive distribution rights. Lastly, public trading of the units allows an MLP to raise funds from a broader range of investors than a private partnership.The federal tax code limits partnership tax treatment to MLPs earning at least 90 percent of their income from certain sources, including, among other things, income and capital gains from natural resource activities. Until recently, eligible natural resources included only oil, gas and petroleum products, coal and other minerals, timber and other resources subject to depletion under the federal tax code. However, in 2008, the definition was expanded to include industrial source carbon dioxide and alternative fuels such as ethanol and biodiesel. Qualifying activities associated with these natural resources include exploration and production, mining, gathering and processing, refining, compression, transportation and storage, marketing and distribution. In addition to the tax criteria, whether a business fits well in an MLP depends on the predictability of its cash flows. Because MLPs must pay minimum quarterly distributions, businesses that provide stable income streams are good MLP candidates. Most MLPs are in the “midstream” portion of the energy business, comprising processes that occur between the source of the commodity and its end point. However, some MLPs exist in the exploration and production segment.Oklahoma’s robust natural resource industries are positioned to thrive during this period of tax increases, and another of our historically robust industries, agriculture, is also poised to benefit from new opportunities. Increased federal funding for biofuels, coupled with the recent inclusion of that industry into qualifying-income status for MLPs, should create opportunities for Oklahoma business.Richard Carson, an attorney with GableGotwals, counsels MLPs in their formation, initial public offerings and ongoing operations, growth and governance.